Final regs. clarify basis and distribution issues, but leave unanswered questions.

• Author: Jamison, Robert W.
• Position: Part 1

EXECUTIVE SUMMARY

Through the use of numerous examples, the first part of this two-part article examines the final regulations under Secs. 1367 and 1368, which shed light on the election of an S corporation split tax year, stock and debt basis issues and adjustments, and accumulated adjustments accounts. Part II, in the June issue, will address distributions to shareholders.

Introduction

The Subchapter S Revision Act of 1982 (SSRA) created new rules for determining a shareholder's stock and debt basis and developed new distribution rules. Although the Code provisions(1) were reasonably clear in many routine situations, guidance was lacking in others. Between 1982 and June 1992, the primary sources of assistance were the instructions to Form 1120S, U.S. Income Tax Return for an S Corporation; Publication 589, Tax Information on S Corporations; and letter rulings. In June 1992, the IRS issued proposed regulations(2) under Secs. 1367 and 1368 that provided some useful basis and distribution rules (as well as a number of confusing statements and cross-references).

In December 1993, the IRS issued final regulations(3) under Secs. 1367 and 1368, largely a restatement and refinement of the proposed regulations; some rules were added and various problems addressed that were not covered in the proposed rules. Although the final regulations provide welcome guidance, there is room for improvement.

This two-part article provides an in-depth discussion of the final regulations under Secs. 1367 and 1368, explores some new planning opportunities and pitfalls, and addresses certain ambiguities. Part I, below, examines disposition and basis rules and accumulated adjustments accounts (AAAs); Part II, in the June issue, will discuss distributions to shareholders.

Termination of Tax Year on Substantial Disposition

SSRA Section 2 enacted Sec. 1377(a) (2) to provide that an S corporation can elect to split its tax year into two portions on termination of a shareholder's interest. Sec. 1377 does not define "termination of interest," but specifically delegates authority to regulations. Temp. Regs. Sec. 18.1377-1,(4) issued in 1983, required complete termination of a shareholder's interest before the split-year election was available.

Regs. Sec. 1.1368-1 (g) (1) defines termination more liberally--either a complete termination or a "qualifying disposition" will allow an S corporation to split its tax year. Regs. Sec. 1.1368-1 (g) (2) (i) (A)-(C) define three types of qualifying dispositions:

1. Disposition by one shareholder of at least 20% of the corporation's outstanding stock in any 30-day period within the corporation's tax year.

2. A redemption treated as an exchange under Sec. 302(a) or 303(a) of at least 20% of the corporation's outstanding stock, from one shareholder, during any 30-day period within the corporation's tax year.

3. Issuance of new stock by the corporation, to one or more new shareholders during any 30-day period within the corporation's tax year.

   Thus, there are now four possibilities for an interim closing. In some instances, an S corporation may have two or more qualifying dispositions within the same tax year.

   * Observation: Regs. Sec. 1.1368-1 (g) (2) (B) permits an interim closing on a stock redemption treated as an exchange under Sec. 302(a) or 303(a). However, a redemption that does not meet one of these exchange tests may still permit a split-year election under Sec. 1377 (a) (2); Temp. Regs. Sec. 18.1377-1 allows the election when any shareholder terminated his entire shareholder interest.(5) Thus, an S corporation could redeem all of the stock of a shareholder who still retains a "forbidden" interest (e.g., as an officer or a director) and/or an indirect shareholder interest (i.e., through the Sec. 318 constructive ownership rules). This redemption would not qualify as an exchange under Sec. 302, but should be a termination of an entire shareholder interest purposes of a split-year election.

   Electing a Split Year

   Under Regs. Sec. 1.1368-1 (g) (2) (iii), the corporation makes the election by attaching a statement to its timely field original or amended Form 1120S. Regs. Sec. 1.1368-1 (g) (2) (ii) states that the election is used only for allocation and distribution purposes (i.e., the corporation does not file a separate 1120S for each period). Similarly, the election to split the year does not accelerate the reporting of income or loss to shareholders. By limiting the effect of the election to allocations of income and loss, distributions and basis, the election to split a tax year prevents the corporation from multiplying annual limitations (such as Sec. 179 deductions). Further, no portion of a split year is counted as a separate tax year for purposes of Sec. 1363(b) (4), which applies Sec. 291 to former C corporations for their first three tax years as S corporations. As is discussed in Part II of this article, a split-year election does not allow the corporation and its shareholders to make bypass elections (including the deemed-dividend election) for separate portions of the year.

   According to Regs. Sec. 1.1368-1 (g) (2) (iii), the corporation must obtain consent from each shareholder who held stock at any time during the entire tax year (without regard to the split). However, that regulation then states that a shareholder is a shareholder as described in Sec. 1362 (a) (2), which refers to all persons who were shareholders the date of the S election.

   * Observation: Regs. Sec. 1.1368-1 (g) (2) (iii) literally requires the consent to split years to be obtained from all persons who were shareholders on the day the corporation filed Form 2553, Election by a Small Business Corporation (which may have been as early as 1958), even if these persons no longer have any interest in the corporation. That regulation probably intends to provide that consent is required from any person who would be considered a shareholder during the tax year of the split, including shares owned under community property laws or other form of joint ownership. A change in the cross-reference from Sec. 1362 (a) (2) to Regs. Sec. 1.1362-6(b) (2)(6) would probably achieve the desired result and eliminate confusion.

   Basis Rules

   Stock

   In general, Sec. 1367 requires that an S shareholder adjust stock basis for his share of the corporation's income, losses and deductions. The positive adjustments include both tax and tax-exempt income, under Sec. 1366(a) (1) (A); the negative adjustments include allowable deductions and losses under that section, as well as the corporation's nondeductible, noncapitalizable expenses. Basis must also be reduced for all distributions not included in the shareholder's income (e.g., distributions from accumulated earnings and profits (AE&P)). Sec. 1368(b) provides that distributions that exceed the shareholder's basis are treated as gains from the sale of the shareholder's stock.

   Items adjusting stock basis: Secs. 1367(a) (1) (A) and 1366(a) (1) (A) provide that a shareholder's basis is increased for his pro rata share of the corporation's items of income, including "tax-exempt income," an undefined term. A logical interpretation would be to treat any item excluded from gross income under Secs. 101-137 as tax-exempt income; however, the IRS's position is that an S corporation's cancellation of debt income excluded by Sec. 108 is not tax-exempt income for purposes of Secs. 1366 and 1377.(7)

   Similarly, Secs. 1367(a) (2) (B) and 1366(a) (1) (A) require a shareholder to reduce basis for expenses and losses of the corporation "the separate treatment of which could affect the liability for tax of any shareholder." Neither the Code nor the legislative history amplifies this statement. Regs. Sec. 1.1367-1 (c) (2) provides that the corporation's nondeductible expenses and losses reduce a shareholder's basis; further, the following (nonexclusive) list of disallowed expenses must be reported to shareholders, and reduce their bases:

   * Illegal bribes, kickbacks and other payments disallowed by Sec. 162(c).

   * Fines and penalties nondeductible under Sec. 162(f).

   * Expenses and interest relating to tax-exempt income under Sec. 265.

   * Losses disallowed under Sec. 267(a) (1).

   * Meal and entertainment expenses disallowed under Sec. 274.

   * Two-thirds of treble damages paid for violating antitrust laws disallowed by Sec. 162.

   The aforementioned items are disallowed by the Code as a matter of public policy; although Regs. Sec. 1.1367-1(c) (2) does not mention them, the following items, which are currently nondeductible, also should not be treated as reductions of basis, but for reasons other than public policy:

   * Losses sustained on the distribution of property to a shareholder. This loss disallowance, mandated by Sec. 311 (a), is similar to the loss disallowance under Sec. 267 (a) (1), for which basis reduction is required. In the case of Sec. 267(a) (1) disallowance, the shareholder may use the disallowed corporate loss to offset gain on the future sale of the property. No equivalent provision exists for property acquired by a shareholder when the loss is disallowed by Sec. 311 (a).

   * Expenses of redemptions and reorganizations. Expenses incurred in connection with stock redemptions are disallowed under Sec. 162(k). That section does not explicitly require capitalization; it simply disallows a deduction.(8) However, in addressing this issue prior to enactment of Sec. 162(k), the Supreme Court disallowed appraisal and other expenses relating to a redemption...